** PERCENTAGES MAY NOT ADD UP TO 100% BECAUSE OF THE PROBABILITY OF LARGER OR SMALLER MOVES BEYOND THOSE SHOWN ON THIS TABLE

GOLD CHALLENGES THE US DOLLAR AS CURRENCY OF CHOICE

The
biggest stories in the financial markets today was the government
bailout of AIG, the 450 point drop in the Dow and the 10 percent rise
in gold prices (+$80), which the largest since September 1999.As
we have been warning in prior reports, if global fears persist, there
would come a point where repatriation of US dollars would be
overshadowed by foreign investors liquidating their dollar denominated
investments.We saw that in todayâ€™s price action
with the greenback selling off across the board as gold, the ultimate
form of safe haven becomes the currency of choice. In the eyes of Sovereign Wealth Funds and central banks, commodities including oil may be the safest bet.Supply and demand dynamics for oil have not changed dramatically so $95 oil may be seen as a bargain.Amidst all of the volatility in the financial markets, the one overriding theme is risk aversion.For
that reason, we continue to believe that USD/JPY is the clearest trade
in the currency market as continued uncertainty drags the currency pair
lower.

Government Pulls Out All the Stops, No One is Convinced that it is Enough

The
US government has pulled out all of the stops but the market is not
convinced that the storm has passed. The price action in everything
from stocks, bonds, the US dollar and gold indicates that every new
rescue is having less of an impact. In addition
to spending $85B to bailout AIG, the SEC has also issued new short
selling rules that prohibit naked short selling in all US equities.
Their goal is to reduce volatility and based upon todayâ€™s price action,
it hasn't worked.

Investors
from around the world are nervous and not willing to take on
counterparty risk as trust becomes a commodity these days. LIBOR rates
increased by the most in 9 years indicating that banks have become
extremely cautious about lending. The rates of US Treasury 3 month
bills fell to the lowest amount in 54 years, while the 2 year swap rate
hit a record high. Gold prices surged more than $85 an ounce. The TED
spread, which is the difference between what banks and the Treasury pay
to borrow ballooned to a wider level than Black Monday in October
1987. The degree of these moves proves that there is still a
significant amount of risk aversion in the markets which is bearish for
USD/JPY.

Here's some info that illustrates the significance of todayâ€™s moves:

Weak Housing Data Doesnâ€™t Help Either

Adding further uncertainty to the outlook for the US economy is the current account and housing market data.The deficit widened from $175B to $183B in the second quarter, while housing starts fell 6.2 percent to a 17 year low.Building permits, which is frequently perceived as a leading indicator for the housing market dropped more than 8 percent.With the number of layoffs expected to rise, this holiday shopping season could be particularly grim for retailers.Looking ahead, jobless claims, the Philadelphia Fed index and leading indicators are scheduled for release.Even though we expect dollar bearish numbers, economic data have become nothing more than an afterthought these days.

EUR/USD: INTEREST RATE EXPANSION COULD MEAN A BOTTOM

Since
last Friday, the Euro has rallied close to 500 pips, leading many
people to wonder whether this a real bottom for the EUR/USD.In
order to answer this question, we have to first look at what drove the
EUR/USD down 10 percent in 2 months, which was oil, interest rates and
flight to quality.Between the middle of July
and the first week in September, oil prices dropped close to 40
percent, a possible rate hike by the Federal Reserve was the talk of
town and the US dollar benefitted significantly from safe haven flows.However
now the market is pricing in a 100 percent chance of a quarter point
rate cut at the October FOMC meeting (see table of Fed interest rate
expectations), oil prices have hit a bottom and are trending higher
while the US dollar is no longer a safe haven play.If
the Federal Reserve cuts interest rates over the next 2 months while
the ECB refuses to follow suit, interest rate compression will be
replaced by interest rate expansion in the Euroâ€™s favor.For
these reasons, this could be a true bottom in the EUR/USD at least
until slower global growth forces a more aggressive hand by the ECB.However this does not mean that we expect the EUR/USD to surge to 1.50.Instead, range trading is the more likely course for the currency pair.The
offsetting factors of US investors liquidating their foreign holdings
to raise cash and foreign investors dumping their US investments in
lieu of safer assets should keep the EUR/USD and GBP/USD range bound.Meanwhile
the Swiss National Bank will be making a monetary policy announcement
tomorrow. Interest rates are expected to remain unchanged and any
comments from the SNB should lean towards easier monetary policy.

BRITISH POUND: UP 400 PIPS DESPITE EXCEEDINGLY WEAK ECONOMIC DATA

The
British pound surged 400 pips or more than 2% against the US dollar.
The strength was actually universal with big moves also seen against
the Euro, Japanese Yen and Swiss Franc.Interestingly enough, UK economic data was very weak.The
CBI Industrial Trends survey plunged in the month of September,
reflecting difficult manufacturing conditions while the number of
people of claiming unemployment benefits hit a 6 year high.The Bank of England minutes was also dovish with 1 member voting for a 50bp rate cut.However it seems that possible consolidation in the banking sector has kept the British pound bid.Lloyds TSB is expected to buy HBOS for GBP14 billion, rescuing them from a Lehman style failure.Retail sales are due for release tomorrow.We expect consumer spending to slow, but economic data may be overshadowed by macro drivers.

USD/JPY PLUNGES AS DOW HITS LOWEST LEVEL SINCE OCT 2005 â€“ THIS IS A DOLLAR NOT CARRY TRADE STORY

The sharp sell-off in the US equity market has led to more weakness for USD/JPY and some of the Japanese Yen crosses.As
we have mentioned in the dollar portion of this report, the only clear
trade these days is short USD/JPY as risk aversion drives the currency
pair lower.In fact, it is interesting to point
out that not all of the carry trades or Yen crosses sold off despite
the 450 point drop in the Dow.EUR/JPY or GBP/JPY for example are materially higher.This
suggests that the move is out of dollars and not carry trades because
the rally in the EUR/USD and GBP/USD was more significant than the
sell-off in USD/JPY.

AUSTRALIAN DOLLAR: CONTENDS WITH GOLD RALLY AND RISK AVERSION

The big moves in the financial markets have led to significant volatility in the Australian, New Zealand and Canadian dollars.Despite the $85 rise in gold prices, there has not been a meaningful rally in the Australian dollar.The
currency hit an intraday high of 0.8075, but risk aversion was so
dominant that the Australian dollar actually ended the day weaker
against the greenback.Of the 3 commodity
producing countries, Canada is the only one with data â€“ leading
indicators and wholesale sales are due for release.

USD/JPY:CURRENCY PAIR IN PLAY OVER THE NEXT 24 HOURS

With
the Dow falling 450 pips in the US trading session to the lowest level
since October 2005, USD/JPY will be the currency pair to watch.Even
though the Philadelphia Fed Index and leading indicators are both due
for release at 10:00 AM ET or 14:00 GMT, macro factors and market
sentiment will be the primary driver of USD/JPY.

The currency pair remains within our sell-zone, which is established by Bollinger Bands.The 106.25-50 level is important because the confluence of Bollinger Band (1st standard deviation), Fibonacci levels, the 10, 100 and 200-day SMA creates stiff resistance.If
the currency pair manages to close above 106.25, the downtrend will be
broken but as long as it remains below that level, we expect USD/JPY to
continue to trickle lower towards its not support at 102.35, the 23.6%
Fibo.

By Kathy Lien, Director of Currency Research at GFT

About The Author

Lien
has extensive knowledge within the interbank market, particularly in
trading spot FX and options. She has written for numerous publications,
is frequently quoted on financial media outlets, and is the author of
several books, including Millionaire Traders. Read more

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